Investors today have plenty of things to worry about, however perhaps the biggest is the growing derivatives time bomb.
The Bank for International Settlements (BIS) publishes a list of outstanding derivatives twice a year, and their latest report reveals that the total notional value of outstanding derivatives has increased from $601 trillion as of December 2010 to $707 trillion as of June 2011. Even more alarming is the fact that nearly all of the increase was accounted for by interest rate contracts which now have a notional value of $553 trillion – $219 trillion of which are denominated in Euros.
The majority of banks have large loan books at fixed interest rates for long periods, and interest rate derivatives are designed to protect them should interest rates rise. A significant rise in interest rates would trigger claims on these derivatives, and if just 10% of the derivatives contracts denominated in Euro’s produce a loss, the global banking system would incur a $22 trillion loss.
Beware the bond vigilantes.